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Updated 10/06/99


Began looking at how prices are formed in a market economy as a first step CEILINGS
toward understanding how individual decisions are coordinated in markets. FLOORS
Market prices reflect the interactions of two different forces: demand and supply. INFLATION
The quantity demanded varies with the price of the good, the price of substitutes PROCUREMENT
and complements, expected future prices, income, tastes
and population. Holding all variables constant except the price of the good (ceteris paribus), we decided
there should be a negative relationship between price and the quantity demanded (the income and
substitution effects). Any change in price, ceteris paribus, causes a movement along the demand curve
(i.e., a change in the quantity demanded). Any violation of the ceteris paribus assumption causes the
demand curve to shift (i.e., a change in demand).

Similarly, the quantity supplied depends on the price of the good, the price of inputs, technology, the
price of substitutes and complements (in production), expected future prices, the goals of the firm, and the
number of firms. Holding all variables constant except the price of the good, we decided there should be
a positive relationship between price and the quantity supplied (profits). Any change in price, ceteris
paribus, causes a movement along the supply curve (i.e., a change in the quantity supplied). Any
violation of the ceteris paribus assumption causes a shift in the supply curve (i.e., a change in supply).

Combining the two curves shows the interaction between producers and consumers. The market always
tends to the price that equates the quantity demanded and supplied. This is the point where the demand
and supply curves intersect. If price is above this equilibrium level, there is excess supply. This forces
price down, causing the quantity supplied to decrease and the quantity demanded to increase. The
adjustment process stops when the quantity producers are willing to supply equals the quantity that
consumers are willing to purchase. The opposite adjustment occurs if price is below the equilibrium
value, creating excess demand. Thus, if markets are out of equilibrium (characterized by shortages or
surpluses), market forces will automatically bring the market back into equilibrium. This is how market
prices help coordinate independent actions of individuals. Market economies will appear coordinated as
long as prices are free to adjust to their equilibrium values.

If the government wants to influence market prices, it can operate through the market by imposing taxes
or subsidies. Taxes (subsidies) increase (decrease) the costs of production (recall taxes and subsidies are
both modeled as affecting the supply curve). This shifts the supply curve, and the market will adjust to a
new equilibrium point. Thus, taxes and subsidies can influence equilibrium price and output, but price is
free to adjust to the level that clears the market. Because prices are free to adjust, taxes and subsidies are
considered as operating through the market.

Price Ceilings

Alternatively, the government can choose to supersede the market by imposing price ceilings or floors.
Price ceilings limit prices to values below the equilibrium level (if the limit is set above the equilibrium
level, the ceiling would be ineffective). Price floors limit prices to values above the equilibrium level.
These policies are considered as superseding the market because prices are not allowed to adjust to their
equilibrium values. As a result, price changes can not signal consumers and producers to adjust their
behavior (incentive) and prices do not balance supply and demand (allocation).

For example, consider price ceilings (e.g., rent control, gas price controls, Nixon and post World War II
price and wage freezes, anti-price-gauging laws, etc.). What effect does a price ceiling have on demand
and supply? None. It simply restricts price below its equilibrium value. As a result, there are chronic
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shortages (see figure). Prices cannot rise, so consumers do not get the signal to economize and producers
do not get the signal to expand output.

Furthermore, there is an allocation problem that is not present when demand equals supply. A limited
supply has to be divided up between a greater demand. Thus, we need to create some mechanism to
allocate the scarce supply to consumers. As described in the text, several allocation rules might result:
first come first serve, lottery, favoritism, discrimination, bribes, survival of the fittest, etc. Consumers
will compete to obtain a share of the limited supply, where the rules of the competition are determined by
the allocation mechanism. This competition generally creates costs in addition to the monetary price of
the good (e.g., time waiting in line, bribes, in-kind payments, etc.). This generally increases the total cost
of the good (opportunity cost, including monetary and non-monetary costs) above the ceiling, and even
above the unrestricted equilibrium price. Thus, price ceilings actually increase total costs above the
equilibrium level.

For example, consider ration coupons as suggested for gas in the 1970s. The government prints one ticket
for each gallon of gasoline supplied. To receive a gallon of gas, you must sacrifice the regulated price of
a gallon plus one ration coupon. This eliminates excess demand (though there is criticism about
alternative schemes to allocate ration coupons). There are two cases: ration coupons can be exchanged;
ration coupons are non exchangeable. If ration coupons can be exchanged, what is the market price of a
ration coupon? PC = PD - P' (see figure). If we purchase a gallon of gas with a coupon we have purchased
from someone else, what is the total cost of a gallon of gas? PD = P' + PC (see figure). If we purchase the
gallon of gas with a ration coupon we received for free, what is our total cost of gas? PD, because PC
becomes an opportunity cost. We forgo this value when we decide to use our own coupon rather than
selling it to someone else. What if ration coupons are not exchangeable? Black market, siphon gas, or
other method to circumvent the restrictions. Opportunity cost will still rise by an amount close to the
value when coupons are exchangeable.

Are there differences between exchangeable ration coupons and other allocation schemes? Exchangeable
ration coupons are efficient (they ensure that the good is allocated to consumers who place the highest
value on the good). Other schemes may be inefficient (e.g., lower valued consumers may receive the
good under first come first serve if they have a lower value of time).

Thus, ration coupons and other methods of allocating the limited supply all have the effect of raising the
total cost of the good above the ceiling, and above the unrestricted equilibrium price. Thus, price ceilings
actually have the opposite effect intended. They raise total costs and lower output. Evidence supports
this: low occupancy in apts. under rent control, gas lines, and trekking (40% fall in train rider-ship after
price control were lifted in post World War II Europe). The alternative allocation mechanisms that arise
are generally considered inefficient, unfair, and sometimes immoral.

Price Floors

Next consider price floors (e.g., minimum wage laws, agricultural price supports). What effect do price
floors have on supply and demand? None. They simply hold price above its equilibrium market value.
This also supersedes market responses, so that prices can't adjust to eliminate chronic excess supply.
Consumers don't get the signal that they should expand their consumption and producers don't get the
signal that they should reduce their production. As with price ceilings, prices also don't serve their
allocative role, and other mechanisms have to be developed to allocate the surplus output to the limited
demand (i.e., who gets to sell?). In labor markets, this can lead to discrimination, favoritism, nepotism,
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Price Ceiling


Q' Q* Quantity

To make price floors effective, the government must devise a scheme to deal with excess supplies
(otherwise competition between sellers would lead to attempts to circumvent the floor). What policies are
used in labor markets? Unemployment compensation. What are some of the policies used in agriculture?
Create new demand, pay not to harvest/pay not to grow, government purchases at guaranteed prices, and
price supports. Should U.S. consumers care which policy is adopted? Price supports result in greater
output at a lower price (compared to the market equilibrium). All other policies result in higher prices
and lower output (compared to the market equilibrium). (See figure)

Which set of policies is the best? Market based policies (taxes/subsidies) are preferred by economists to
policies tht supersede the market (price ceilings/floors). Both sets of policies can influence price, but
market based policies retain price flexibility so that the market can adjust to equilibrium. Thus, prices
play their allocative role, and we don't have to create alternative allocative mechanisms. In addition,
consumers and producers will still respond appropriately to changing market conditions (i.e., shifts in the
supply and demand curves). With price ceilings/floors, consumers and producers may not respond to
changing market conditions because price may be precluded from changing. What policy do you think
politicians prefer? Price ceilings and floors. Why? Taxes are unpopular and subsidies increase the
federal budget. Furthermore, price ceilings/floors are more tangible, therefore easier to convince
constituents that positive steps are being taken.

Supply Supply

P' P'
Total Demand
P P Demand
Q' Q Quantity Q' Q Quantity

Create New Demand Pay to Plow Under/ Not Grow

Supply Supply

Total Demand
P' P'

P Demand P Demand

Q' Q Quantity Q Quantity

Government Purchases Government Price Supports

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What if we have inflation? How will it affect supply and demand? Shift? Movement along the curve?
Neither. Inflation is a general increase in all prices (including wages). If all prices and wages increase by
the same percentage, nothing will change. We will make the same decisions after inflation as before. (In
reality, inflation pushes some people into higher tax brackets. As a result, they pay a higher percentage of
their income in taxes. This reduces the purchasing power of their income and reduces consumption of all
normal goods. This is called the inflation tax, but is ignored here.) Throughout this course, we will
measure prices in real terms (i.e., correct for inflation). Therefore, we can ignore inflation. However, if
price changes more or less than the rate of inflation, that is a real price change which signals a change in
the goods relative scarcity. Real price changes are important because they cause consumers and
producers to respond in appropriate ways.


Now we can be fairly comfortable with our description of the supply and demand curves and movements
versus shifts in the curves. This enables us to predict the direction that equilibrium price and output will
move as market conditions change. Can we get a little more precise. For example, can we predict
whether price and output will change by a lot or by a little?

What determines the relative decrease in equilibrium price and increase in quantity when supply
increases? The shape of the demand curve (see figures below). If the demand curve is flat, price only
decreases slightly while quantity increases by a relatively large amount. In this case, the quantity
demanded is very responsive to changes in price. When supply increases, creating excess supply at the
old equilibrium price, a small decrease in price will cause the quantity demanded to increase sufficiently
to absorb the excess supply. On the other hand, if the demand curve is steep, an increase in supply causes
price to fall substantially but the quantity demanded will only increase slightly. In this case, the quantity
demanded is not very responsive to price. Therefore, price must fall significantly to eliminate any excess
supply. In the intermediate case, price and output change moderately.

Can we develop a measure for the shape of the demand curve? The obvious choice is the slope, but that
depends on the units of both the horizontal and vertical axes. To eliminate units, we use percentage rather
than absolute changes. Thus, the shape of the demand curve is measured by the elasticity of demand
which is defined as Ed = -%∆ Q/%∆ P (the negative sign ensures that Ed ≥ O). If the %∆ Q > %∆ P, Ed
> 1. In this case demand is considered elastic. In other words, consumers are flexible (as a piece of
elastic) and respond to changes in price. This corresponds to a flat demand curve. If %∆ Q < %∆ P, Ed
< 1 and demand is inelastic. In this case, consumers are not flexible (like a dried out piece of elastic) and
the quantity demanded won't respond to changes in price. If %∆ Q = %∆ P, then Ed = 1 and demand is
unitary elastic. In this case, both price and quantity change by a moderate amount. (Note that elasticity is
the inverse of the slope in that the horizontal change is the numerator while the vertical change is the
denominator. This departure from convention was adopted so that elasticity would be greater than one for
elastic demand and less than one for inelastic demand.)

How do we actually calculate Ed? Without calculus:

− (Q 2 − Q1 )
− ∆Q
(Q 2 + Q 1 )
− % ∆Q Q 2
Ed = = =
% ∆P ∆ P ( P2 − P1 )
P ( P2 + P1 )
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For example, if the demand curve is given by P = 10 - Qd, the elasticity of demand as we move from P1 =
2, Q1 = 8 to P2 = 1, Q2 = 9 is:

− ( Q 2 − Q 1 ) − ( 9 − 8)
(Q 2 + Q 1 ) ( 9 + 8) −1
Ed = 2 = 2 = 8.5 = 0.176
( P2 − P1 ) (1 − 2) −1
( P2 + P1 ) (1 + 2) 15
2 2

This estimates Ed at the midpoint between the two points in question (i.e., at Q = 8.5, P = 1.5).

Supply Supply

P ∆

Q Quantity ∆
Q Quantity

Supply Elastic
Unitary Elastic



Demand Ed =0.176

Q Quantity Quantity 8 9

With calculus:

− dQ P
Ed = *
dP Q

This calculates the elasticity of demand at the point (Q,P). For example, the demand curve above can be
rewritten as Qd = 10 - P. Thus,

dQ − dQ P P
= −1 ⇒ E d = * = −1 *
dP dP Q Q

For the point Q = 8.5, P = 1.5, Ed = 1.5/8.5 = 0.176, which is the same value as calculated above.
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What can we say about the elasticity of a straight line demand curve? Nothing. Ed approaches infinity at
vertical intercept. As you move down along the demand curve, elasticity decreases and approaches zero
at the horizontal intercept. Why does Ed vary if the slope of the line is constant? Because the base for
calculating the percentage changes varies. At the vertical axis, P is large and Q is small. Thus, a small
movement down the demand curve creates a large percentage change in Q and a small percentage change
in P. Thus Ed is large (elastic). At the horizontal axis, Q is large and P is small. This time, the same
movement along the demand curve causes a small percentage change in Q but a large percentage change
in P. Ed is small in this case. At the mid-point of the line, Ed = 1. Because of the percentages, you
cannot look at a demand curve and make absolute statements about its elasticity, but you can compare the
relative elasticity of two different demand curves.

What determines elasticity of demand? Availability of substitutes, expenditures relative to budget,

durability, time period.

Suppose you hear that the Monterey bus system is losing money. They are considering raising bus fares
to increase their total revenues. Is this a good idea? It depends on elasticity of demand. If demand is
inelastic, the percentage change in quantity is less than the percentage change in price, and revenue
moves in the direction of price. If demand is elastic, the percentage change in quantity is greater than the
percentage change in price and revenue moves opposite to price. (Mathematically, TR = PxQ => MR =
dTR/dQ = P + (dP/dQ)Q = P + P(dP/dQ)(Q/P) = P(1 - 1/Ed). If Ed < 1, MR < 0 and TR decreases as Q
increases and P decreases. If Ed > 1, MR > 0 and TR increases as Q increases and P decreases.) What is
a better scheme? Raise fares during peak hours, when Ed < 1, and lower them in off peak hours, when Ed
> 1.

Is another OPEC oil embargo likely for purely economic reasons (i.e., not for political reasons)? In
1970s, OPEC controlled 70% of the market. If they reduced output by 10%, total quantity decreased by
7%. To increase revenues, they would need a 10% or greater increase in prices. This would occur if Ed <
0.7. This was true at first. Over time, Ed increased and new suppliers entered. In the late 1980s, OPEC
controlled 40% of the world market. To secure the same 7% decrease in world output, OPEC would need
to reduce output by 17.5%. For their revenues to increase price would have to increase by more than
17.5%, which would require Ed < 0.4 (and no increase in output from non-OPEC producers). This is
unlikely over a significant period of time.

Other definitions of elasticity include:

Elasticity of Supply: Es = %∆ Qs/%∆ P, (0 ≤ Es ≤ 1);

Income Elasticity: Ey = %∆ Qd/%∆ P, (Ey > 0 => normal good; Ey < 0 => inferior good);

Cross Elasticity: Exy = %∆ Qdx/%∆ Py, (Exy > 0 => substitutes, Exy < 0 => compliments).